Earnings Magic? Big Rebound in Profits May Be Coming

Corporate earnings are expected to be just short of awful in the third quarter and then stage a fairly dramatic turnaround the rest of this year—and analysts believe the rebound will last into 2013.

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So how does that happen?

After all, the conditions present in the current quarter can't change that much in the next three months. Or can they?

Analysts, in fact, are betting that a confluence of factors — the ending of what some hope is just an economic soft patch, an influx of newly minted money from the Federal Reserve and European Central Bank, and a presidential election, to name three — will help change the earnings story.

"A lot of market commentary seems to forget that at least in the old way of thinking about the market, investors are looking ahead six to nine months as much as they're regarding the immediate surrounding circumstances," says John Carey, a portfolio manager at Pioneer Funds, which manages $194 billion for clients. "The market has been holding up and having a few days of significant strength, despite conditions which don't seem so reassuring."

Indeed, the stock markethas been on a tear lately, with the Standard & Poor's 500 gaining more than 13 percent year to date and within striking distance of its 2007 all-time highs.

That has come amid worries over persistent economic weakness as unemploymentstays above 8 percent, consumers retrench and geopolitical troubles in Europe and Washington continue to boil.

Yet earnings projections say the slowness will be short-lived.

While this quarter could see earnings per share declines of 2.1 percent, growth is expected to hit 10.2 percent in the fourth quarter and 11.7 percent for 2013, according to Reuters estimates.

But Dan Greenhaus, chief global strategist at BTIG in New York, cautions against reading too much into the earnings projections as a signal of economic strength.

Instead, he says, the numbers are inflated by "base effect," which simply means that because growth was so weak a year ago — particularly in the fourth quarter of 2011, when earnings barely moved — this year's numbers have a very low bar to clear.

"Let's be clear: The reason why the market is going up is because of multiple expansion. Earnings estimates are coming down but the stock market is going up because people are becoming enthusiastic about likely central bank accommodation in Europe and the United States," Greenhaus says. "We've seen this movie several times before, and each time we've seen the market multiple expand. That's exactly what's happening now."

Central banks have been in high gear in terms of accommodation, and earnings expectations seem anchored to monetary policy as well as a few other factors.

The Federal Reservelast week announced an unprecedented measure to continue easing each month, with an open-ended program of quantitative easingthat will be tied specifically to the unemployment rate.

Also, American voters will cast their presidential ballots in November, possibly paving the way on negotiations to avert a series of spending cuts and tax hikes that will kick in unless Washington can agree on deficit reduction.

To be sure, not everyone is so convinced that the health of corporate America will improve, with or without the Fed and the ECB, which has shown its intentions to ease in order to staunch the euro zone's sovereign debt crisis.

After all, S&P 500 companies are coming off a quarter in which earnings grew less than 1 percent as only half beat earnings estimates and just 36 percent topped sales expectations.

Every sector but health care missed on revenue projections, "with the highly foreign-exposed and commodity-exposed sectors seeing the biggest misses amid a stronger dollar, lower than expected commodity prices and slowing global growth," Savita Subramanian, equity and quant strategist at Bank of America Merrill Lynch, said in a note to clients.

Subramanian said earnings estimates remain "unrealistic" and the fourth quarter projections are likely too high by 6 percent.

For their part, companies continue to take down their third-quarter expectations, though the negative ratio has come down some over the past four months. Currently, a net 10.2 percent of the S&P 1500 companies have issued negatively revised forecasts, according to Bespoke Investment Group.

That isn't stopping investors from buying into the notion that the stock market can keep rising even if earnings don't quite meet their lofty expectations for future quarters.

"You're at the point in the cycle where earnings growth slows down. That's undeniable," Greenhaus says. "But even moderate earnings growth is still earnings growth, and that's the point of the cycle in which we find ourselves."